NO

Claims Should Reflect True Economic Impacts

By William D. O'Connell and Harvey N. Michaels

In its Accounting Research Bulletin No. 43 the American Institute of Certified Public Accountants defines depreciation as follows:

A system of accounting that aims to distribute the cost or other basic value of tangible capital assets less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner. It is a process of allocation not of valuation.

Depreciation is an application of the fundamental accounting principle of matching costs with revenues. Each period of time that obtains the beneficial use of an asset is charged with an appropriate share of its total cost less salvage value. Depreciation represents a decline in service potential of an asset which may be the result of physical deterioration, inadequacy due to increased demands resulting from higher production volume, consumption through use, or loss in economic value due to obsolescence.

The allocation of the cost of an asset requires an estimate of the total service life of the asset, a selection of an allocation methodology to determine the portion of the total cost assignable to each year of the asset's service life, and an estimate of the salvage value at the end of the service life. The required estimates are based upon judgment, and as such are uncertain. In most instances, the method of allocation to arrive at the amount of depreciation to be charged annually to the accounts is a matter of choice of one method from possibly several acceptable methods. Therefore, no allocation method is completely defensible as being superior to all others.

Insurance claim analysis

For the purposes of this discussion, it is assumed that an insured company uses a unit of production method for calculating the depreciation charge for the capital assets. This method of depreciation is based on the assumption that the cost of assets is best amortized as a function of use rather than a passage of time or technological change.

The accounting impact of an insured incident is that lower amounts of depreciation would be expensed during the interruption period than otherwise would be the case had no loss occurred.

In a loss settlement situation, the insurance adjuster's position frequently is that some portion, if not all, of the reduction in depreciation expense during the interruption period is a saved expense and should be deducted from the lost gross earnings in arriving at the ultimate business interruption claim. The argument usually presented is that depreciation is a charge to earnings to reflect the wear and tear on the facilities and this wear and tear was avoided or saved during the interruption period.

Arguments to refute this approach which could be presented to the adjuster include the following:

1) Business interruption insurance proceeds are an attempt to place the insured, as far as money can do, in the same financial position as the insured would have been had no loss occurred. Periodic depreciation, a book entry, does not properly enter into the determination of the impact on the financial position of a company. Depreciation is an accounting charge and is not a current or future cash inflow or outflow. The deduction of depreciation would violate the underlying concept of indemnity inherent in a business interruption insurance policy.

2) Depreciation represents the accounting allocation of historical sunk costs to accounting periods. Once the asset is purchased, the cost becomes fixed and the accounting allocation methodology chosen makes no difference. As the costs are sunk, the cessation of the allocation of those costs is irrelevant in the computation of a business interruption insurance claim.

3) Any depreciation method used is somewhat arbitrary and inherently includes many assumptions. Different amounts of depreciation could validly be recorded by an insured company. Each of these depreciation methodologies would yield a different business interruption claim amount if depreciation is deducted as a saved expense. The choices made and assumptions used should not impact the measurement of the loss sustained.

4) The amount and timing of the periodic depreciation charge has been altered as a result of an insured loss. In a loss year, lower amounts are charged to the accounts, while in a later year, higher amounts are charged Furthermore, restricting the calculation of the fluctuation to the loss period does not address the entire issue. The depreciable base of the replacement assets upon reconstruction of the facilities will be higher than the base at the time of the loss. Therefore, the insured will be recording higher depreciation charges in years subsequent to the interruption. These differences in book entries in no way affect the determination of the economic (cash) amount required to put the insured where it would have been financially had no loss occurred.

5) Generally, upon receipt of physical damage insurance proceeds, the insured will book an accounting gain on the "disposal" of its assets. The "gain" will be the amount by which the physical damage proceeds exceed the remaining net book value of the assets at the time of the loss. This clearly is also a non-cash item. To utilize the same reasoning which the adjuster may propose to deduct "saved" depreciation, a further reduction to the business interruption claim would be made for this "gain." It is obvious (even to adjusters) that this would be an improper calculation of the loss amount.

Policy analysis

Business interruption insurance policies, both the gross earnings and profits forms, contemplate treating depreciation as an insured item. The gross earnings form inherently covers all expenses outside the definition of gross earnings. Commonly used gross earnings statement of values worksheets do not mention depreciation, as it is not a component of gross earnings It is only in the application of the phrase "less charges and expenses which do not necessarily continue during such interruption" that depreciation is considered a saved item by the adjusters. A demonstration that depreciation is not saved enables the proper amount to be recovered under the terms of a business interruption insurance policy.

The profits form, while not explicit as to the treatment of depreciation in itself, at least addresses depreciation. The profits form extends coverage for the loss of net profit before tax (after deducting depreciation) plus "standing charges," defined as expenses which do not diminish proportionately with a reduction in revenues. In common statement of values worksheets used for the profits form, it is recognized that depreciation is such an expense and is included as a standing charge.

Unfortunately, both types of policies leave the arguments of whether or not a non-cash item is to be considered as a saved expense to the claim adjustment process. However, we believe it is the intent of both types of policies to indemnify the insured and to put it in the same financial position as it otherwise would have been had no loss occurred.

Many business interruption policies indicate that the recovery in the event of a loss shall be the "actual loss sustained" by the insured resulting from an interruption of business. Policies usually then go on to state how the loss is to be calculated. Using a cash in bank example, it can be argued that the determination of the actual loss sustained does not require a deduction for depreciation.

Finally, the insured values usually do not include a deduction for depreciation. Therefore, insurance premiums are charged on the higher, cash-based calculation.

Additional points for discussion

Depreciation is based on an estimate of useful service life. The estimates used to calculate annual depreciation charges may differ significantly from actual service lives at the time of the loss. Annual maintenance programs, debottlenecking programs, and capacity expansion programs may have extended the life of the assets significantly as compared to the original estimates. In this case, the accounting charges for depreciation will be in excess of the results which would be achieved if these longer service life estimates were used.

In the determination of the actual cash value for physical damage claim purposes, adjusters use remaining service life estimates. These estimates should be compared to the remaining life used for depreciation accounting purposes to determine if lower amounts of depreciation are indicated through the adoption of the adjuster's estimate of remaining life.

To move the discussion from an argument relating to non-cash book entries to one relating to actual cash expenditures, the insured may put forward the argument that a proper determination of physical depreciation is made through an examination of maintenance expenditures. If the premise is accepted that depreciation due to obsolescence and wear and tear is offset through the expenditure of maintenance dollars, then the claim should be reduced only for the saved maintenance expenses. This may be acceptable, as saved maintenance expense is usually deducted from business interruption claim calculations.

Conclusion and recommendations

The irrelevancy of non-cash items in insurance claims needs to be highlighted. The actual economic value of settlements is not determined by referring to an asset's net book value, current replacement cost or selected depreciation factors. The adjuster should not consider an amount derived through the use of an arbitrary depreciation accounting technique as a proper deduction in the determination of a business interruption insurance claim.

This article was originally published in the September 1995 issue of Claims Magazine

William D. O'Connell, CPA, CFE, CMC, is the director of business insurance consulting at the multinational professional services firm of Deloitte & Touche. He is based in Dallas. Harvey N. Michaels, CFE, CMC, is assistant director of business insurance consulting for Deloitte & Touche, based in Houston.

YES

How Can Destroyed Property Still Exist?

By Chris Campos and and Raymond J. McErlean

Our belief has always been that when a covered peril that destroys an asset also results in a business interruption loss, the depreciation on the destroyed asset ceases and cannot be considered a continuing expense during the period of interruption.

Recently, there have been various arguments advanced as to why depreciation should not be a discontinued expense in business interruption losses. We have examined their arguments and have found them to be groundless. The following summaries their arguments and our point-by-point response to these arguments.

One argument against the discontinuance of depreciation is that depreciation is a non-cash item which is a somewhat arbitrary accounting or tax write-off of previously expended capital payments. We agree that depreciation is an allocation of previously expended capital payments and that it is a non-cash item. However, depreciation expense is meant to be a systematic and rational allocation of cost over the estimated useful life of assets. Thus, it is not arbitrary.

The argument that depreciation should not be discontinued because it is a non-cash item has an interesting twist. This argument is made in connection with a gross earnings policy where discontinued expenses are deducted from gross earnings to arrive at the compensable loss. If one were to use the "non-cash" argument in a gross earnings loss, then what would the position be under a business income policy or a loss of profits policy, where profit plus continuing expenses is the measure of the loss? Would the claimant then exclude depreciation (because it is a non-cash item) in calculating continuing expense where the related asset has not been destroyed? It would not be proper to do that, nor do insurance companies or their adjusters take such a position. Their position to discontinue depreciation (albeit a non-cash item) when the asset is destroyed is an equally valid and consistent position.

Depreciation distributes the cost of an asset over its estimated useful life so that the cost of the asset can be matched to the revenue which that asset helps to generate When an asset is totally destroyed, it can no longer be used productively. The generally accepted accounting treatment is that depreciation expense ceases when an asset is destroyed.

When an insurer reimburses the insured for property destroyed, the asset being reimbursed is effectively sold to the insurance company. A gain is recognized on the insured's books for the amount of insurance proceeds over the remaining undepreciated cost of the old asset. In most cases, the reimbursement provides sufficient funds to replace the destroyed asset. Thus, the insured has recovered the initial cost of the asset and would not be entitled to any additional recovery, such as continued depreciation, under the business interruption coverage.

Another argument states that by discontinuing depreciation expense, the insurer violates the principle of indemnity. In order to violate the principle of indemnity, there must be a loss that is not reimbursed under the policy. When an asset is destroyed, depreciation ceases and the insured is reimbursed for the destroyed asset under the property portion of the policy.

We believe that the principle of indemnity supports our position that depreciation should be discontinued, since the insured would receive a benefit if it were to receive payment for continued depreciation on a destroyed asset in addition to being reimbursed for the destroyed asset. The principle of indemnity means the insured should not benefit from a loss but should only be compensated for its actual loss, which is the result when depreciation is discontinued on a destroyed asset.

A position has been advanced that discontinued repairs and maintenance expenses might be a better measure of saved physical depreciation since annual maintenance programs may extend the life of an asset significantly beyond the original estimate. However, accounting principles dictate that any expenses which extends the life of an asset must be capitalized, not expensed. Therefore, such expenses would not appear as maintenance expenses on the income statement but as additions to the capital assets on the balance sheet. Our belief is that repair and maintenance expenses should be discontinued in addition to depreciation expense. If an asset is destroyed, none of these expenses will be incurred while the asset does not exist.

Another position is that, since depreciation expenses are included in the value on which business interruption insurance premiums are paid, these expenses should not be discontinued in the loss measurement. This argument reflects a basic misunderstanding of how insurance premiums are calculated and how insurance losses are paid The method of paying premiums has nothing to do with how losses are paid. The measurement of a business interruption loss under a gross earnings policy is gross earnings less all expenses that do not necessarily continue, or, under a business income policy, net profit before taxes plus continuing expenses. Many expenses in addition to depreciation are insured, but none of them are recoverable if they do not continue after a loss occurs. Only those insured expenses which continue after a loss are recoverable. When an asset is destroyed, the depreciation on that asset ceases and is thus not recoverable.

An argument is made that the insured is no better off economically through saved depreciation. This is not true. There should he no depreciation recorded in the books of the insured from the date of loss until the property is restored. At the date of restoration, the destroyed property has been replaced with a comparable asset. In most cases, this gives the insured a more efficient, newer, modern asset with a longer useful life than the destroyed asset would have had absent the casualty. Clearly, this represents an economic advantage to the insured.

Another argument is made by insureds or their representatives that the insurance company will not reimburse the insured for future increased depreciation charges resulting from the higher cost or replacement assets. Therefore, the argument continues, to compensate for this increased depreciation, the insured should be paid for phantom depreciation between the date of loss and the replacement of the asset.

Increased depreciation charges occur when the insured has replacement coverage and the funds to replace any destroyed assets are provided by the insurance company. The insured has effectively traded a partly used-up (depreciated) asset for a new one with a full lifespan and technological and other product improvements. The insured would then record the insurance proceeds as if there were a sale of the asset. Accordingly, there is normally a gain recorded as a result of the casualty.

The gain equals the excess of the insurance proceeds attributable to the destroyed asset over the undepreciated cost of that asset. The increased depreciation charges represent the difference between the cost of the new asset and the undepreciated cost of the destroyed asset, which is the same as the gain recorded by the insured as a result of receipt of insurance payments. Thus, the increased depreciation results from the insurance company having paid the insured an amount greater than the undepreciated cost on its books for the destroyed asset Thus, there is an over all "wash" between the gain and the increased depreciation.

In instances where the insured does not have replacement coverage, the above does not apply. In those instances there would be increased depreciation charges over and above any recorded gain. However, this situation occurs because the insured elected not to obtain coverage for the replacement cost of its assets.

There is an argument that the estimated life used to determine depreciation expense may vary significantly from the actual service life of an asset. This is true. In fact, in some instances adjusters have changed the depreciation method used by the insured to reduce the charge and, subsequently, the amount of depreciation expense being discontinued. However, this approach still recognizes that depreciation on a destroyed asset should correctly be considered a discontinued expense.

It is understood that the amount of loss under business interruption coverage does not include any charges or expenses which become unnecessary during cessation of business operations. The basic concept of business interruption coverage is that all expenses are insured subject to the policy provision excluding "charges and expenses which do not necessarily continue during such interruption." Depreciation on destroyed property is obviously an unnecessary charge.

Business interruption is in most cases an endorsement to the property policy. In the case of a piece of machinery or equipment being totally destroyed by an insured peril, property damage coverage responds to such a loss. Just as an insured wouldn't continue to depreciate a piece a of equipment it sold or disposed of itself, it is not correct to continue depreciation on a piece of equipment "sold" to the insurer. In summary, we do not believe any of the arguments against discontinuing depreciation, which we summarized above, address a real problem or ambiguity in the current handling of depreciation expense in business interruption claims. Thus, our opinion is still that depreciation expense on destroyed property should be discontinued.